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A Friend Of Ben With A Bold Idea

September 16, 2007

The Federal Reserve Board usually moves with elephantine majesty. But a fast-talking New Yorker on its Board of Governors, Frederic S. Mishkin, has broached the idea that the Fed could prevent a lot of damage from a severe housing slump by acting swiftly and cutting interest rates aggressively even before the slump's impact on the broad economy is evident.

Mishkin's presentation, based on a paper he prepared for the conference, didn't directly pertain to what Fed rate-setters will do at their next meeting on Sept. 18. That's because he analyzed a hypothetical housing decline that's much deeper than the one the U.S. has seen so far--a 20% decline in inflation-adjusted prices over two years. In contrast, U.S. home prices measured by the Office of Federal Housing Enterprise Oversight are roughly flat over the past year after inflation.

But the paper is important because it outlines a different way to conduct monetary policy. Traditionally, the Fed doesn't cut interest rates until it sees concrete evidence that the economy is slowing. Mishkin says the harm that falling house prices do to the economy is predictable, so there's no sense waiting until the damage is done. By acting quickly, he theorizes, the Fed can buoy consumer spending and minimize the loss in economic output while suffering only a small bump up in the inflation rate. Such a policy, he writes, "can be extremely successful at counteracting the real effects of [a] very large housing slump."

While Mishkin refrained from discussing current monetary policy at Jackson Hole, other economists have been less shy, with some suggesting a cut in the federal funds rate of a full percentage point to avert a housing-led recession. Millions of subprime adjustable-rate mortgages are tied to short-term interest rates that the Fed influences. By reducing those benchmark rates meaningfully, the Fed could keep many adjustable rates from being reset beyond borrowers' ability to pay. "The Fed is already behind the curve," David A. Rosenberg, North American economist at Merrill Lynch & Co. (MER), wrote on Sept. 4.

PROACTIVE

Staying ahead of the curve is Mishkin's key idea. He suggests cutting rates as soon as home prices begin to fall--and raising them just as quickly once prices stop dropping. The required cuts would actually be slightly less than the total under a typical monetary policy, because they would forestall part of the economic decline. Rates would hit bottom a bit more than two years after a price decline begins. Under a traditional strategy, Mishkin says, rates wouldn't hit bottom until three or four years after a housing slump takes hold--and economic output would suffer a much bigger hit.

Although Mishkin's paper reflects his personal view, it may shed light on how Bernanke's Fed would respond to a financial crisis bigger than the one we've seen so far. Before joining the Fed, both Mishkin, who was at Columbia University, and Bernanke at Princeton University argued that central banks should manage interest rates to hit a target rate for inflation. From that, some Fed watchers concluded that under Bernanke, the central bank would focus single-mindedly on inflation and respond grudgingly to declines in the price of such assets as homes and stocks. But Mishkin's paper suggests that inflation targeting isn't at odds with reacting quickly to market turbulence if it is likely to affect future growth and inflation.

Jan Hatzius, chief U.S. economist at Goldman, Sachs & Co. (GS), says Mishkin's paper was "the most interesting contribution" at Jackson Hole. By choosing such a prominent forum to deliver his message, Mishkin signaled that inflation targeters can move quickly when they need to.